The Saudi Surprise

Summary

Every 7-10 years the world needs to find the equivalent of a Saudi Arabia (268 BBO) in terms of oil reserves, to replace depleting reservoirs (cf. BP, XOM annual reports).

In the last 20 years we have fallen short of replacing the burn rate (now 34 BBO/yr.) every year, meaning we are drawing more and more oil from old fields.

The reserves/production (R/P) ratio for Saudi Arabia is 2.8 times the rate for US tight oil plays, but there is a big problem with the accuracy of Saudi data.

OPEC producers will not be physically able to sustain extreme levels of production nearly as long as many seem to think, so prepare for the Saudi Surprise.

On June 20th of 2014 crude oil closed at $101/barrel on the world market, and gasoline in the US cost on average $3.69/gallon. At the time, this was not considered worthy of very many headlines about the impact on consumers, as they had long since grown used to it. Recently, on January 20th, 2016, or just 19 months later - crude oil has reached a price of $28.33/barrel (down 72%) on the spot markets, and gasoline in the US has dropped to an average $1.97/gallon (down 47%). In comparison, the inflation-adjusted (based on CPI) price of oil at its peak in December, 1979 was around $117/barrel, and this fell to a low of about $24/barrel in early 1986, recording a drop of about 79% in inflation-adjusted terms, over a six-year period. Another great crude oil crash occurred in the Great Financial Crisis of 2008, when the inflation-adjusted price fell from $136.55 in June, to a low of $34.60 in February of 2009, thus recording a crash of about 75% in inflation-adjusted terms, in just eight months. Therefore, we have just seen one of the top three price crashes for energy in the last 100 years. Naturally the question arises as to what has driven prices to decline so extremely.

The consensus view, and one that is well-documented, is that there is a surplus in supply, based primarily on the incredibly rapid increase in US shale oil production over the last five years, and also on recent decisions by OPEC to defend market share by driving the price down through increased production. Many are obsessed with the question of how low it (prices) can go, but I am more concerned with how long these prices will last. It makes sense to start working towards an answer by evaluating global supply and demand, but I will leave that to the many others who are working this part of the problem. I want to take on the second part of the analysis, one that I think is equally necessary and useful, with a semi-quantitative evaluation of an additional factor controlling future prices, namely reservoir quality.

Worldwide oil demand at the end of 2015 was 95.05 MMBO/D, and has been growing at a long-term average pace of about 1.5%/year (or 1.44 million barrels/day/year) according to the IEA. Most analysts (e.g. BP, XOM, etc.) believe that this demand growth has been driven primarily by the economic growth of developing countries like China, India, Indonesia, Brazil, Mexico, and the many smaller economies in Africa and the Middle East. However, there are also somewhat less important contributions to global oil demand growth from continuing population growth and/or increased economic activity in more developed economies like those in the U.S., Japan, and Europe. Oil spare capacity is only about 2 MBO/D, even in the midst of the current surplus, according to the EIA. These trends are expected to continue for quite some time, according to The Wall Street Journal and Financial Times.

If these trends do continue, every 7-10 years we will need to add the equivalent production of a new Saudi Arabia (with stated reserves of 268 billion barrels) to world oil production. This statement has been true for at least a decade, but we have seen nowhere near the required gigantic amount of new oil reserves actually being added. What we have seen is greatly increased production, but not so greatly increased reserves, compared to the world requirement of about 268 billion barrels/decade. Even a great shale play like the Bakken in North Dakota and Montana has only added on the order of 24 billion barrels of new reserves. The USGS has recently estimated that total undiscovered reserves in all US onshore basins combined are probably about 49 billion barrels. Proved reserves in total are another 40 billion barrels or so. The US shale and tight sands revolution has thus supplied something like 89 billion barrels of new reserves, which is tremendous for the US, but represents only about 36% of the global supply increase estimated to be needed in the next decade.

Click to enlarge

Note the distinction here, which is absolutely critical. We can boost short-term production with technology, but the quality of that production is nothing like that of a Saudi Arabian giant field like Ghawar. Let's look at this with a back-of-the-envelope calculation for comparison purposes. Let's use the EIA's 2014 production data to estimate what is called a reserves/production (R/P) ratio. Total US tight oil production in 2014 was 1.057 billion barrels, and the related reserves were estimated at 13.365 billion barrels, which gives us a R/P ratio of about 12.64. Now let's look at Ghawar Field, which produced on the order of 5.840 million barrels/day, or about 2.132 billion barrels in all of 2014. The reserves under Ghawar are estimated at about 75 billion barrels, so the R/P ratio is 35.178. This ratio is nearly 3 times as high as the US tight sands ratio! This means that the US production is by necessity short-lived at its present level of daily production, assuming no further drilling is done. This makes a lot of sense, because the average decline rate on shale wells is about 70% in the first two years. Hence the compelling need for nearly continuous drilling in these plays to keep production growing and cash flow healthy. This, plus greatly reduced prices, explain why many firms have been slow to cut production.

Ghawar Field Geologic Cross-Section, USGS

But now we are seeing drilling activity plummet in the shale plays, and even allowing for increased efficiency, it seems inevitable that at some point in the next few months we will see really major declines in oil production in many of these US shale plays. It is hard to predict how deep or fast the decline will be, in part because these are non-linear processes. Anyway, this eventual decline will help to cause the long-expected stabilization of WTI crude oil prices, and maybe an eventual strong rally. But there is another problem with the assumptions most observers have used to estimate future global supply and demand. Few have mentioned that the Saudi Arabians will not be able to maintain their high production levels of recent months for all that much longer, based purely on the physics of oil production. Similar problems are going to pop up in other countries in the OPEC cartel as well. Part of the problem is that the stated reserves for much of OPEC are grossly inaccurate, due to huge increases in reserves that were complete fabrications, generated for economic and political reasons back in the 1980s. This happened when OPEC moved to a reserves-based system for allocating production quotas.

Now, it is true that the Saudis have drilled many new wells in the last 10 years, so reserves have climbed significantly. It seems very unlikely though that the Saudi Arabians have made up the entire gap of around 100 billion barrels that they created out of thin air back in the 1980s. I would also point out that many of these new wells were horizontal, implying that there may have been problems with reservoir quality and continuity of production, as well as just development drilling. Faulting in the major fields has made the Saudi reservoirs more complex than originally thought, so some of the giant fields may be comprised of numerous smaller reservoirs sharing a single gigantic structural oil trap. But in my mind, as an experienced geologist, drilling horizontal wells in giant oil fields is likely a form of enhanced recovery, generally used to stave off production declines in very old fields.

If the reserves are grossly overstated, then the reserves/production (R/P) ratios are possibly much lower than we think. There are physical limits at each level of R/P ratio as to how much you can pull from an oil reservoir daily and not cause permanent damage to the reservoir. Early explorers found this out the hard way, which is why every oil state in the US has well-spacing rules for each play in every basin, and why some states cap the amount of daily production that can be taken from every well.

Let's put this all in perspective. The primary secular trend in crude oil supply can be summarized as follows: for the last 20 years we have been burning 25-35 billion barrels of oil (BBO) per year globally (and more almost every year), but have only been discovering 6-18 BBO of new reserves per year. This means we have been drawing down reserves much faster than we could replace them for a very long time. The global decline ratio was as high as 9% a few years ago, and has likely not improved as all the great oil fields have become fairly old within their expected life spans. In 2007, the discovery rate exceeded 15 BBO as reported by the Oil & Gas Journal, with exciting deep water discoveries of about 13 BBO in offshore Brazil alone. From 2010 to 2015 the discovery rate in the US alone exceeded 7 BBO a couple of times. However, these may be the exceptions that prove the rule, since lower oil prices have already caused the cancellation of over $200 billion in oil exploration and production spending, so the discovery rate is likely to plummet. This long-term global discovery trend is obviously far below the goal mentioned above of discovering the equivalent of a new Saudi Arabia (268 billion barrels) every 7-10 years.

Incredibly, the EIA, in a study published a few years ago, projected future discoveries of 8 times current proved reserves in the U.S., 3 times current proved reserves in the rest of the non-OPEC world, and 2 times current proved reserves in OPEC countries over the next 20 years or so. There is absolutely no geological evidence to support such rosy projections, and even the EIA gave them a low probability. Indeed, the opposite is true: we will find ever smaller fields at ever greater expense, and prices will have to rise to support the effort. Even in places where the reserves are likely actually there, like Iraq, the estimated production increases are laughable. Iraq is expected to add at least another 4 MMBO/D in just a few years, but huge portions of their oil basins are occupied by either ISIS or the Kurds, and a coherent development plan that could reach such lofty goals does not likely exist under these constraints.

The results of these four major problems (lower US production, lower global exploration success, declining older fields, and most importantly, the shockingly misstated or fictitious OPEC reserve estimates, will in the end have a big impact on supply and demand, sooner than most people imagine. I believe we will see the beginning of a global production decline much sooner than the consensus, and that all the talk of how long Saudi Arabia's currency reserves will support them in the years ahead will prove to be irrelevant. The entire OPEC cartel will need to cut back on their extreme levels of production or face doing permanent damage to their reservoirs. I think the world is going to see the bottom for oil prices and a strong rally, in much less time than many expect, courtesy of the Saudi Surprise.

Additional disclosure: BWCA is a state registered investment adviser in all states in which it is required to be registered. All Blue Water Capital Advisors' customer assets are held in the customer's name with TD Ameritrade Institutional Services, clearing through TD Ameritrade Clearing, Inc, Member FINRA/SIPC, TD Ameritrade Inc. a Qualified Custodian.

Disclosure:I am/we are long BP, XOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.